§ The Optimal Debt Level
§ R&D Intensive Firms
§ Typically maintain low debt levels
§ Low current FCF – needs for tax shield or controls for
management spending are small
§ Risky business strategies mean high agency costs of debt
§ Biotechnology and technology firms often maintain less than
10%
§ So far, we have assumed that managers, stockholders, and
creditors have the same information
§ Manager’s information about the firm and its future cash
flows is likely to be superior to that of outside investors –
asymmetric information
§ Asymmetric information may motivate managers to alter a
firm’s capital structure
§ Leverage as a Credible Signal
§ “Actions speak louder than words”
§ In a situation where a firm needs to convince its investors
of good future prospects, it can
§ Launch investor relations campaign
§ Commit the firm to large future debt payments – credible signal of
the CEO’s confidence (signaling theory of debt)
§ Issuing Equity and Adverse Selection
§ Adverse selection – applies in any setting in which the
seller has more information than the buyer
§ Lemons principle – when a seller has private information
about the value of a good, buyers will discount the price
they are willing to pay due to adverse selection
§ Issuing Equity and Adverse Selection (cont.)
§ This principle applies also to the equity market
§ Suppose the owner of a start-up company offers to sell you
70% of the stake in the firm – you suspect the owner may
have negative information about the firm’s future prospects
and is simply trying to cash out
§ Implications for Equity Issuance
1. The stock price declines on the announcement of an
equity issue
2. The stock price tens to rise prior to the announcement of
an equity issue
3. Firms tend to issue equity when information asymmetries
are minimized, such as immediately after earnings
announcements
§ Implications for Capital Structure
§ Because managers find it costly to issue equity that is
underpriced, they may seek alternative forms of financing
such as retained earnings or debt
§ Pecking order hypothesis – managers will prefer to use
retained earnings first, and will issue new equity only as a
last resort
§ The most important insight regarding capital structure
goes back to Modigliani and Miller – with perfect capital
markets, a firm’s security choice does not change the value
of the firm
§ Thus, the optimal capital structure depends on market
imperfections, such as taxes, financial distress costs,
agency costs, and asymmetric information
